08 A p r i l V o l u m e b y G l a c i e r R e s e a r c h

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 08 A p r i l V o l u m e Will investor sentiment dictate capital flows amidst a possible downgrade of South Africa s sovereign debt rating? Written by: Shawn Phillips, Junior Research & Investment Analyst at Glacier by Sanlam A lot has been said recently in the media regarding the possibility of whether South Africa (SA) will be downgraded to junk status by the respective rating agencies, namely Moody s, Standard and Poor s (S&P) and Fitch. An emphasis has been placed on the implications for our stumbling economy, the government, corporates, consumers and what the government is required to do in order to avoid a possible downgrade. SA can be described as a country with low growth, high inflation, high unemployment and income inequality, which is abetted by poor skills development and a dysfunctional labour market. Over the past year, SA s economic and political climate has deteriorated significantly, protests have intensified, growth has come to a standstill, interest rates have spiked, and business confidence has taken a blow from President Jacob Zuma s actions and his defence by the African National Congress (ANC). This article will focus on understanding what a sovereign credit rating is, what junk status means for SA and its citizens, as well as what is required from SA in order to avoid an inevitable downgrade. Highlights from Pravin Gordhan s press conference During a press conference held in March 2016, following his roadshow to the United Kingdom and the United States, Finance Minister Pravin Gordhan stated that the South African government needs to work together with South African labour and business in order to deliver clear demonstrable signs of progress in reforms, as opposed to defaulting to talking about good intentions and vague plans in order to restore investor confidence. He said that government aims to stabilise public debt below 50% of GDP and would like to ensure that SA s foreign currency debt does not exceed 10% of the total debt in issue. Gordhan emphasised his political concerns for SA in the wake of President Jacob Zuma s decision to replace Finance Minister Nhlanhla Nene as well as the ongoing pressures on the National Treasury. F U N D S O N F R I D A Y 08 A p r i l 2016 Page 1

2 Ultimately, in order to determine the outlook for creditworthiness and a country s prospective sovereign credit rating, one needs to address the macro-economic, social and political factors that underpin a country s ability to service its debt. Each respective rating agency mentioned above utilises various measures that allow them to gauge a country s social, economic and political position which results in a sovereign credit rating. What is a sovereign credit rating? A sovereign credit rating expresses the risk that a country will be unable to meet its financial commitments, in terms of repaying interest payments and the debt principal on a timely basis. Essentially, a sovereign credit rating is aimed at providing a relative ranking of a country s overall credit worthiness. Table 1 below depicts the sovereign credit ratings by the respective rating agencies. Table 1: Sovereign credit ratings Moody's S&P Fitch Aaa AAA AAA Highest quality Aa1 AA+ AA+ Aa2 AA AA Aa3 AA- AA- A1 A+ A+ A2 A A A3 A- A- Baa1 BBB+ BBB+ Baa2 BBB BBB Baa3 BBB- BBB- Ba1 BB+ BB+ Ba2 BB BB Ba3 BB- BB- B1 B+ B+ B2 B B B3 B- B- Sovereign credit rating Credit rating meaning High quality Strong payment capacity Adequate payment capacity Likely to fufil obligations, ongoing uncertainty High risk obligations Sub-investment grade Sub-investment grade Source: Barclays Emerging Market Research As it stands, Moody s has rated SA as a Baa2 rating which is two notches above sub-investment grade ( junk status ), while S&P and Fitch have rated SA as BBB- which is one notch above junk status. Moody s has recently placed SA on review for a downgrade, citing low growth and a lack of fiscal sustainability as the reason for the negative outlook. This downgrade could potentially take place at any point in time this year, but SA s sovereign credit rating is still two notches above junk status, implying that a possible downgrade would not be disastrous. S&P is due to issue a review of SA s sovereign credit rating on 3 June 2016, where it cites a possible downgrade if the current political pressure on Pravin Gordhan continues. Page 2

3 Essentially, downgrades through the investment grade floor (i.e. junk status ) are a tough call for the rating agencies, given that many institutional mandates are only allowed to invest in investment grade assets. A downgrade could potentially trigger a crisis that might otherwise have been avoided. As a result, rating agencies are reluctant to downgrade through the investment grade floor unless the political and economic rationale is overwhelming. Furthermore, an important but unappreciated distinction between the sovereign credit ratings is the rating between the foreign currency (FC) denominated debt and the local currency (LC) denominated debt as these ratings are used for institutional mandates in terms of the respective global bond indices. Distinguishing between our LC and FC debt rating FC denominated debt is characterised as debt that is issued in a currency other than the sovereigns own currency (i.e. South African issued government bonds in US$, yen or euros), while LC debt is debt that is issued in local currency (i.e. ZAR). Table 2 displays SA s LC and FC debt ratings by the respective rating agencies. Furthermore, it is important to note that it is SA s FC denominated debt rating that is in the firing line in terms of a possible downgrade. Table 2: South Africa s Local and Foreign currency denominated debt ratings Local and foreign currency long-term debt rating Moody's S&P Fitch LC&FC FC LC FC LC Ratings Baa2 BBB- BBB+ BBB BBB+ Outlook Negative Negative Stable Date of outlook change Dec-15 Dec-15 Dec-15 Date of last rating change Nov-14 Jun-14 Dec-15 Next review rating date Has not announced a specific date yet 03 June June 2016 Source: Barclays Emerging Market Research As seen above in Table 2, Moody s has one rating which applies to both the LC and FC denominated debt, while S&P and Fitch distinguishes between SA s FC and LC debt ratings. Moody s rates SA as Baa2 which is two notches above junk status ; S&P rates SA s FC as BBB- which is one notch above junk status, while it rates SA s LC as BBB+ which is three notches above junk status ; and Fitch rates SA s FC as BBB which is two notches above junk status, while it rates SA s LC as BBB+ which is three notches above junk status. In terms of the respective rating agencies, S&P is of great concern as SA s FC debt rating is only one notch above junk status, while it is two notches above junk status for both Fitch and Moody s. Page 3

4 What does a downgrade imply for SA and its citizens? The bottom line is that if SA were to be downgraded to junk status in terms of its FC debt, then it will cost SA more to borrow money in global markets. Currently, SA has a budget deficit, implying that the government spends more than it earns, whereby the deficit is funded via loans from large international bodies through issuances of South African government bonds. Furthermore, South African consumers are highly indebted and continue to finance their lifestyles through debt and the cost of servicing this debt will become more expensive. Generally, as seen in past sovereign downgrades, the direct impact is felt in the bond and fixed income market through rising interest rates. This should be accompanied by an upward shift of the yield curve. A secondary shock is felt in our local currency, as the rand would weaken against major currencies. This is then translated into the equity market as investor sentiment could possibly lead to a sell-off as investors deem SA assets to be more risky. Is a downgrade inevitable? Yes, a downgrade is inevitable across both the LC and FC debt rating, however in the case of S&P, it will only be our FC debt rating that will be considered as sub-investment grade. For Moody s if a possible downgrade were to take place, then SA s LC and FC debt rating will be one notch above junk status, while for Fitch if a downgrade were to take place then our LC debt rating will be two notches above junk status and our FC debt rating will be one notch above junk status. Moreover, it is important to note that institutions that offer credit in a specific country cannot have a higher sovereign credit rating than the sovereign itself, implying that banks and corporates will be downgraded along with its respective sovereign. Will SA bonds be removed from global bond indices? No, as these bond indices typically use the country s LC debt credit rating when deciding on the inclusion and exclusion of a country s government bonds. General commentary tends to focus on the possible downgrade of SA s FC debt rating, where an emphasis is placed on the large sales of bond holdings by foreign investors as South African government bonds would be excluded from some of the world bond indices. Currently, SA s foreign denominated debt in relation to total government debt is roughly 10% of the approximately R2.18 trillion in issue. For a country like SA, what matters is our LC debt credit rating as the bulk of our debt is domestically issued (i.e. ZAR). Any downgrade in the FC debt rating will have a negative effect on investor sentiment, however it will be difficult to say what effect this will have on bond capital flows. In an ideal world, the LC debt rating should be the same or perhaps even better than the FC debt rating as investors would like the government issuing the debt to be able to meet its debt obligations. Considering the fact that only local currency bonds are included in the Barclays Global Aggregate Index and Citi s World Government Bond Index, if SA s FC debt rating were to be downgraded to junk status, then SA government bonds will still remain in both respective indices. In terms of the mandate required for the two respective bond indices: the Barclays Global Aggregate Index requires securities to have at least a middle investment grade rating, which is equivalent to a Baa3 rating from Moody s and a BBB- rating from S&P and Fitch; while Citi s World Government Bond Index requires an investment grade rating from either Moody s or Page 4

5 S&P. Essentially, only if SA s LC debt rating becomes sub-investment grade (i.e. junk status ) then only will SA government bonds be in jeopardy in terms of inclusion in the respective indices. Is this the end of the cliff for SA? No, SA government bonds have already priced in most of the bad news associated with a downgrade. However, it is difficult to say what impact a knee-jerk reaction by investors will have on the bond and fixed income markets. Lower bond yields internationally implies that South African bonds will still remain attractive for investors on a relative basis. According to the rating agencies, SA requires a range of remedial policy measures, some of which will be politically challenging for the ANC. These measures will hinge on the government s ability to stick to its fiscal consolidation path, despite low economic growth and high interest rates. Even if these measures are implemented, it is important to realise that the impact required in order to avoid a possible sovereign downgrade will not happen overnight. Page 5